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391
WHAT’S NEW IN THE SIXTH EDITION:
Two new
In the News
features have been added: “Arrow’s Problem in Practice” and “Sin Taxes.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how to examine problems caused by asymmetric information.
CONTEXT AND PURPOSE:
Chapter 22 is the last chapter in the microeconomics portion of the text. It is the second of two unrelated
chapters that introduce students to advanced topics in microeconomics. These two chapters are intended
to whet their appetites for further study in economics.
22
FRONTIERS OF
MICROECONOMICS
392 ❖ Chapter 22/Frontiers of Microeconomics
KEY POINTS:
• In many economic transactions, information is asymmetric. When there are hidden actions, principals
may be concerned that agents suffer from the problem of moral hazard. When there are hidden
characteristics, buyers may be concerned about the problem of adverse selection among the sellers.
Private markets sometimes deal with asymmetric information with signaling and screening.
CHAPTER OUTLINE:
I. Asymmetric Information
A. Many times in life, one person holds more knowledge about what is going on than another. Such
a difference in access to relevant information is known as an
information asymmetry
.
B. Examples
1. A worker knows more than his employer about the level of his work effort. This is an
example of a
hidden action
.
D. Hidden Actions: Principals, Agents, and Moral Hazard
1. Important Definitions
This is a great chapter to get students interested in further study of economics. It is
important for the students to learn that economics is a growing and developing
science and that economists are always looking for new areas to study and new
phenomena to explain.
Chapter 22/Frontiers of Microeconomics ❖ 393
2. The employment relationship is the classic example.
a. Workers (agents) may be tempted to shirk their work-related responsibilities because
their employers (the principals) do not monitor their behavior closely.
3.
FYI: Corporate Management
a. From an economic standpoint, the most important feature of the corporate form of
organization is the separation of ownership and control.
E. Hidden Characteristics: Adverse Selection and the Lemons Problem
1. Definition of adverse selection: the tendency for the mix of unobserved attributes
to become undesirable from the standpoint of an uninformed party.
2. Examples include the used car market, the labor market, and the market for insurance.
3. When markets suffer from adverse selection, the invisible hand does not necessarily work
well.
a. In the used car market, owners of "cherry" or "plum" cars may choose to keep them
rather than sell them at a low price.
394 ❖ Chapter 22/Frontiers of Microeconomics
F. Signaling to Convey Private Information
1. Definition of signaling: an action taken by an informed party to reveal private
information to an uninformed party.
4.
Case Study: Gifts as Signals
a. Because people know their own preferences better than anyone else, we would expect
that they would prefer cash gifts.
G. Screening to Uncover Private Information
2. Examples of Screening
a. A buyer of a used car may ask to have the car examined by a mechanic prior to
purchase.
H. Asymmetric Information and Public Policy
1. Market failures such as externalities, public goods, imperfect competition, and poverty show
that governments can sometimes improve market outcomes.
Seinfeld, “The Deal.”
(Season 2, 15:50-18:50). Jerry gives Elaine cash for her
birthday, thinking she can spend it on whatever she likes best. However, Elaine is
mortified; she wanted a thoughtful gift that signaled Jerry had put great thought into
his gift. Kramer enters and does just that—he gives Elaine a thoughtful gift.
Chapter 22/Frontiers of Microeconomics ❖ 395
3. However, three factors make it difficult for the government to improve the outcome in some
cases.
a. The private market can sometimes deal with information asymmetries on its own using a
combination of signaling and screening.
Activity 1—A Market for Lemons
Type: In-class demonstration
Topics: Asymmetric information, signaling, regulation
Materials needed: Prepared instruction sheets and record sheets
Time: 50–60 minutes
Class limitations: Works in any size class, although using a larger number of groups
will result in a larger amount of time necessary to complete each
round
Purpose
This classroom experiment demonstrates how a market for lemons can develop when buyers
Instructions
Divide the class into seven groups, three sellers and four buyers. Try to keep the groups
separated and make sure that students know not to reveal their cost or value information to
anyone. Pass out instruction sheets and record sheets for each group. Here are the rules for
the first few rounds of the game:
1. Sellers must decide their product quality and price simultaneously. Each seller can
choose only one product quality but can sell up to two units each period. Sellers'
decisions are recorded and given to the instructor.
Quality 1 Quality 2 Quality 3
Cost of 1st unit $1.75 $4.95 $11.35
Cost of 2nd unit $2.75 $5.95 $12.35
396 ❖ Chapter 22/Frontiers of Microeconomics
II. Political Economy
A. Definition of political economy: the study of government using the analytic methods of
economics.
B. The Condorcet Voting Paradox
5. For the buyers, consumer surplus will be the difference between the value to the
consumer (given on their instruction sheets) and the price paid. The value for each
Points for Discussion
Begin by discussing the results of the rounds where buyers and sellers had complete
information.
1. Do sellers or buyers benefit from a higher quality of product?
2. What is the most efficient quality? (Which maximizes total surplus?)
3. Suppose the market ended up with only Quality 2 products? Would it be efficient for a
regulator to force firms to manufacture Quality 3 products? Why or why not?
1. What happened in the market when buyers were unable to distinguish the product
quality?
2. Why were firms driven to produce the lowest quality?
3. In reality, is there any way for a firm to reveal the quality of its product?
Chapter 22/Frontiers of Microeconomics ❖ 397
3. Example: Three possible outcomes (A, B, and C) and three voter types (Type 1, Type 2, and
Type 3). The mayor of a town wishes to aggregate the individual preferences into
preferences for society as a whole.
Voter Type
Type 1
Type 2
Type 3
Percent of Electorate
35
45
20
First Choice
A
B
C
C. Arrow's Impossibility Theorem
1. In a 1951 book, economist Kenneth Arrow examined if a perfect voting system exists.
2. He assumes that society wants a voting scheme that satisfies social properties.
a. Unanimity.
3. Arrow proved that no voting system could have all of these properties.
4. Definition of Arrow impossibility theorem: a mathematical result showing that,
5. Arrow’s impossibility theorem implies that no matter what voting scheme society adopts for
Table 1
398 ❖ Chapter 22/Frontiers of Microeconomics
6.
In the News: Arrow’s Problem in Practice
a. The voting system chosen matters in all types of situations.
D. The Median Voter Is King
2. Definition of median voter theorem: a mathematical result showing that if voters
are choosing a point along a line and each voter wants the point closest to his
3. One implication of the median voter theorem is that if two political candidates are each trying
4. Another implication of the median voter theorem is that minority views are not given much
weight.
E. Politicians Are People Too
1. Politicians may be self-interested.
Figure 1
Chapter 22/Frontiers of Microeconomics ❖ 399
III. Behavioral Economics
A. Definition of behavioral economics: the subfield of economics that integrates the
insights of psychology.
C. People Aren’t Always Rational
1. Economists assume that human beings are always rational.
a. Firm managers maximize profit.
2. Real people are often more complex than economists assume.
3. Studies of human decisionmaking have found several systematic mistakes that people make.
a. People are overconfident.
D. People Care about Fairness
1. Example: the ultimatum game.
a. Two volunteers are told they are going to play a game and could win a total of $100.
400 ❖ Chapter 22/Frontiers of Microeconomics
3. In reality, when the offer made to Player B is small, Player B often rejects it.
5. This implies that people may be driven by a sense of fairness.
E. People Are Inconsistent over Time
1. Many times in life, people make plans for themselves but then fail to follow through.
F.
In the News: Sin Taxes
1. If people are inconsistent over time, tax policy could be used to address the problem.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. Buyers of life insurance will likely have higher than the average death rates. Two reasons for
this are moral hazard and adverse selection.
Moral hazard is the tendency of a person who is imperfectly monitored to engage in
dishonest or otherwise undesirable behavior. After purchasing insurance, an insured person
I Love Lucy, “The Sublease.”
(Season 3, 0:31-4:07). The Ricardos sublet their
apartment for an amount greater than they pay the Mertzs. The Mertzs think this is
unfair and won't allow the sublease to take place.
Chapter 22/Frontiers of Microeconomics ❖ 401
2. According to the median voter theorem, if each voter chooses a point closest to his preferred
3. Human decision making can differ from the rational human being of conventional economic
theory in three important ways: (1) people aren’t always rational, (2) people care about
fairness, and (3) people are inconsistent over time.
Questions for Review
1. Moral hazard is the tendency of a person who is imperfectly monitored to engage in
2. Adverse selection is the tendency for the mix of unobserved attributes to become undesirable
3. Signaling is an action taken by an informed party to reveal private information to an
uninformed party. Job applicants may use a college diploma as a signal of ability. Screening
4. Condorcet noticed that the majority rule will fail to produce transitive properties for society.
5. The median voter’s preferences will beat out any other proposal in a two-way race because
the median voter will have more than half of the voters on his side.
6. Two volunteers are chosen and a coin toss determines which volunteer is Player A and which
is Player B. Player A proposes a split of a sum of money and then Player B decides whether
to accept or reject the proposal. If Player B accepts, the sum of money is divided as outlined
402 ❖ Chapter 22/Frontiers of Microeconomics
Problems and Applications
1. a. The landlord is the principal and the tenant is the agent. There is asymmetric information
because the landlord does not know how well the tenant will take care of the property.
Having a tenant pay a security deposit increases the likelihood that the tenant will take
care of the property in order to receive his deposit back when he vacates the property.
2. Individuals who are relatively healthy may decide to forgo purchasing the policy if the
3. Saying "I love you" is likely not a good signal. To be an effective signal, the signal must be
costly. In fact, the signal must be less costly, or more beneficial, to the person with the
higher-quality product. Simply professing one's love does not meet this requirement.
4. If insurance companies were not allowed to determine if applicants are HIV-positive, more
individuals who are HIV-positive would be able to purchase insurance, but that insurance
5. If the needy are given cash, they can use the cash to purchase whatever they most desire.
This will increase their utility by more than if the government predetermines what they
6. Ken is violating the property of independence of irrelevant alternatives. Adding a choice of
Chapter 22/Frontiers of Microeconomics ❖ 403
7. a. If the three friends use a Borda count, the Chinese restaurant gets the most votes (10);
the Italian restaurant gets 9 votes; the Mexican restaurant gets 7 votes; and the French
restaurant gets 4 votes.
8. a. There would be a tie between the three television shows, with 6 votes each.
b. In a vote between
Dexter
and
Glee
,
Dexter
would win. In a vote between
Dexter
and
House
,
House
would win. Thus, Monica’s first choice (
House
) would win.
9. a. The efficient number of DVDs is three. Total surplus would be the sum of the roommates’
willingness to pay (38 + 26 + 18 = 82) minus the cost of the DVDs (15 + 15 + 15 = 45)
which is 37.
b. Quentin would want 4 DVDs; Spike would prefer 3; Ridley wants 2; Martin wants 1; and
Steven does not want to buy a DVD.
10. You can consider only the outcome of one race. This is problematic, as Arrow’s impossibility
theorem rules out the possibility of such a dictatorship. An alternative would be to use a
Borda count. But, this violates the third property listed as the outcome would change if one
of the competitors were to drop out.
404 ❖ Chapter 22/Frontiers of Microeconomics
12. a. An earthquake occurring in California does not increase the probability that another will
occur. Thus, nothing that affects the benefits from such insurance has really changed.
The individuals are simply putting more emphasis than necessary on the event. However,
if it were true that the individuals had no idea of the possible risks until the earthquake
occurred, then purchasing the insurance would be a rational thing to do.
